KEY POINTS:
The consensus view of experts and many in the industry seems to be that to save the finance company debenture market we need, among other things, more government regulation, independent ratings of the firms and for Mum and Dad to do their homework better.
But are debentures a legitimate asset class for retail investors and does knowing about the company you have invested with make any difference when it hits the wall?
Independent ratings certainly offer no panacea. Even the legitimate rating agencies, Moodys and Standard & Poors, are facing a torrent of complaints in the United States that they didn't warn investors about the sub-prime debacle and CDOs.
Here are four good reasons why retail investors should avoid finance company debentures completely:
* Finance company debentures offer no diversification benefits. The fixed interest component of a portfolio protects against deflationary conditions, whereas real assets such as property and shares protect against inflation. When economic conditions deteriorate and shares plunge in value, low-risk bonds become relatively attractive as the "market" anticipates lower real growth and lower inflation.
In contrast, at the first sign of trouble higher-risk bonds change their spots and turn into equities. Their prices nosedive along with other risky assets.
In industry terms, interest rates "bifurcate" - low-risk bond yields fall (prices go up) and high-risk yields rise (prices go down). The fixed interest component of a balanced portfolio should thus primarily be confined to the debt of those institutions which are too big to fail, like the biggest banks or bonds issued by the Government and state-owned enterprises.
Today's interest rates from safe bonds aren't that much different to finance companies and they come with the dual advantage of liquidity if you need funds in the interim, and of giving you your money back at the end of the term.
* Listed equity and bond markets price risk more efficiently. If you want higher returns, the property and equity markets are far more effective arbiters of risk as they have institutional investors who do the hard yards and research to keep things priced efficiently in terms of risk and return.
This is because in the equity and debt markets there is a liquid secondary market which gives participants like stockbrokers and institutional investors an incentive to do ongoing research on the issuers.
As anyone who has tried to sell a finance company debenture before it matures knows, there is next to no secondary market in finance company debentures. The primary market, where the finance company itself issues new bonds, is where most of the action is.
This is because the finance company client, Mr Property Developer, effectively pays the entry commissions to a financial planner as part of the all-up cost of the loan.
The significance of this relates to pricing: when the Government issues debt it is priced with reference to the secondary market. With little or no secondary market in finance company debt, who is in charge of price discovery?
In most cases it's the finance company itself, hence the frequent criticism that debenture rates are too low relative to their risk.
* You can't diversify debentures properly. The number one rule for investing in risky assets is "diversify".
A Harvard study reckons you need a minimum of 50 stocks in a share portfolio. There are any number of low-cost, actively and passively managed share funds available providing this vital service, but no unitised vehicle offers a diversified portfolio of finance company debentures.
As people have discovered lately, even owning 10 finance company debentures leaves you taking a big hit at times like this You would have been better leaving the money in the bank.
* Professional investors ignore finance company debentures and even in big portfolios junk debt is invariably a small part of the fixed interest portfolio. Many institutional investors limit themselves to investment grade bonds only (BBB+) because of the risk of bifurcation.
The fact is that finance companies in the main lend to individuals and companies that the banks won't, and no amount of regulation, homework or ratings is going to change that.
Companies that borrow from financial companies invariably have high operational and/or financial leverage; thus, when times get tough they are the first to go under. The best strategy for Mum and Dad may well be to just give the whole sector a miss.
* Brent Sheather is a Whakatane-based investment adviser
